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Looming Partial Gridlock in Washington – Good for the Market

The market can be fickle. Some days, there are “hurricanes” of bad news and the market seems to chug along. Other days, a whisper of a wind seems to send
the market into turmoil. What is moving the market today is most likely due to investor fears around weakness in the global market, strengthening of the US
dollar and the unwinding of quantitative easing.

In recent days, we have seen the CBOE Volatility Index, a.k.a., the VIX, hit a 1-year high and it has only been higher once in the past two years. The VIX
is a relative measure of the premium placed on options. Options are essentially insurance. When the risk is perceived to be higher, the price of insurance
goes up. That is what moves the VIX.

With the VIX, there is a bit of a “chicken and the egg” thing. We tend to see a falling market coincident with a rising VIX. It is debatable as to which
is causing which. My observation is that we tend to see the market falling and then the VIX rising. Then the VIX falls, and the market rises. Regardless,
the VIX is a measure of investor sentiment. And, investors are currently fearful.

This could be an opportunity to start creating positions for a future bullish move. There are reasons to be bullish. We have been in a long term economic
recovery, and we have not fully recovered. Key markets, like labor and housing, still have room to go. Earnings continue to be strong, and we have seen a
resurgence in mergers in acquisitions.

However, a reason to be bullish, which may be overlooked by other traders, is the pending partial gridlock from a Republican controlled Congress and a
Democratic-controlled presidency.

Do not confuse this with any political opinion. The phenomenon has been observed and well documented. Consider the book: Trade the Congressional Effect:
How To Profit from Congress’s Impact on the Stock Market by Eric T. Singer. The author notes “…when there is partial gridlock, meaning one party controlled
both houses of Congress, and another controlled the White House, the returns were +12.94 percent.” The author acknowledges that there are some notable
exceptions to that rule, e.g., 1930-1932 during the Great Depression and in 1971 when the dollar went off the gold standard, but those could be
aberrations. The author summarizes “…statistics show that a Republican Senate combined with a Democratic presidency had the most compelling risk-adjusted
nominal return…”

There is some logic behind this. Politics impact markets. Some parts of our economy will fare better, and some will fare worse depending on the political
climate. Additionally, a split government can reduce “legislative risk.” Less risk is seen as being better for the market.

With elections just a few weeks away, it is likely that some of that that uncertainty that is driving the market now.

There may be a way to get some insight to where this is going. Above, I eluded to a Republican controlled Congress and a Democratic controlled presidency.
That is not just wishful thinking. The insight came from the Iowa Electronic Markets. This is an online futures market for real world events. (Visit here
for more information http://tippie.uiowa.edu/iem/)

2012 US Congressional Control Market

Image link: https://iemweb.biz.uiowa.edu/graphs/graph_Congress14_jpg.cfm

The IEM currently has a market trading five possible outcomes for the 2014 Congressional elections:

  • DH_DS14 – Democratic House, Democratic Senate (blue)
  • DH_RS14 – Democratic House, Republican Senate (green)
  • RH_DS14 – Republican House, Democratic Senate (black)
  • RH_RS14 – Republican House, Republican Senate (red)
  • OTHER14 – None of the named contracts payoff (purple)

As of October 12, 2014, the RH_RS14 (in red) was priced at $0.669. The reader can explore the IEM to get more background. However, the future price is
essentially equivalent to the probability of that outcome. So, according to the IEM, there is a 66.9% likelihood of a Republican controlled Senate and
House.

These numbers can – and do – change. As we get closer to November 4, the importance of this election will have more of an impact on the market. If the
current situation continues, I would expect a bullish move in the market.

However, it is important to know that traders would be well advised to have secondary exits planned. If, on November 5, we do not have a clear outcome of
the election or it is not what the market expected, look for a market selloff.

(What happens in presidential elections is even more interesting.
https://www.optionsanimal.com/whats-really-moving-the-stock-market-obama-romney-and-the-presidential-election/)

Eric Hale
OptionsANIMAL Instructor

Protect Your Trades with OptionsANIMAL
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Eric Hale

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